How Mortgage Interest Rates Are Set

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Have you ever wondered how mortgage interest rates are set in Canada?

Well, read on …

With a mortgage being the biggest debt that you will assume – (and hopefully pay off), during your adult life – I thought that you would want to know how Canadian mortgage rates are set.

So I am here to set the record straight!

Mortgage rates are NOT set to the Bank of Canada rate (the “over night rate”)!

But first a lesson in Economics 101…

Bank of Canada (Photo credit: Wikipedia)

The Bank of Canada sets the “target for the overnight rate” meaning that The Bank of Canada operates a system to make sure trading in the overnight market stays within its “operating band”, which is one-half of a percentage point (or .50 basis points) wide, and always has the Target for the Overnight Rate at its centre.

For example, if the operating band is 2.75 to 3.25 per cent, the Target for the Overnight Rate would be 3.0 per cent. (Time of writing: September, 2008)

It is this “overnight rate” that is used as is the interest rate that banks charge each other to cover their short-term daily transactions.

Since the institutions know that the Bank of Canada will always lend them money at the rate at the top of the band, and pay interest on deposits at the bottom, there is no reason for them to trade funds at rates outside the band.

The Bank can also intervene in the overnight market at the Target rate, if the market rate is moving away from the Target.

However, the chartered banks use the overnight rate as a guide in setting their prime lending rate – the rate at which the bank’s best customers can borrow money.

When the central bank changes its overnight rate, it’s sending a signal to the chartered banks that it wants them to change their prime lending rates.

But the rates for fixed mortgages depend on the bond market.

Yield to Maturity (Photo credit: Digital Sextant)

This is because the banks rely on the bond market to raise money for these kinds of mortgages.

Interest rates on the bond market can move up or down more frequently than the prime rate because the bond market is far more sensitive to market fluctuations.

Rates also move when bond traders believe the central bank may be about to increase – or reduce – interest rates.

And how are bond yields determined?

By investors’ expectations for interest rates in the future.

These expectations are arrived at by assessing the state of the Canadian economy and predicting where it is headed relative to other world economies.

There is no science to such predictions (although some economists spend a lot of time trying to make it into a science).

At best the markets make their best guess and keep updating their guess every day.

The central bank moves to higher rates when it believes the economy is in danger of growing too rapidly.

Rapid economic growth could cause a cycle of rising prices and wages.

The central bank wants that growth to be moderate, so inflationary pressures are kept in check.

Conversely, lowering rates from the central bank show that it’s worried that the economy is weakening and people aren’t buying enough big-ticket items.

Lowering rates helps to spur economic growth because it makes it more attractive for businesses and consumers to borrow.

The central bank must be careful not to inject too much stimulus into the economy or it risks igniting inflation.

Of course, correctly forecasting this balance of risks is the central bank’s most difficult and most important task.

OK, now the economics lesson is over…

Sorry about that – however, it’s important to get a fuller understanding about the stuff that have a direct impact on us as Canadian consumers – but is not largely reported – let alone understood.

So, we now know that Canadian, fixed residential mortgage rates are determined by changes in the bond market.

But remember – banks are in business to make profit (oh, and how they do).

What’s their commodity? Money!

How do they make money?

They engage in an activity is called “arbitrage”!

They purchase money at cheaper rates than they loan the money out at – and keep the difference – their profit…

Essentially, they pay their depositors low rates of interest on their bank accounts, term deposits, and GICs and then lend the money out at higher rates through mortgages…often to the very same client – you and I!

The way that they do this is like this:

A Government of Canada bond represents a risk free investment to the banks.

Canadian Parliament Building (Photo credit: ianturton)

Now, when the banks choose to invest in (loan money for) a mortgage, they are taking on added risk with their capital (our deposited money) and incurring costs to set up and service it.

Therefore, as a “prudent business practice” they will set their mortgage rates high enough above the equivalent bond yield to compensate them for their costs and to provide them with a profit margin for the added risk they are taking on.

The “point spread” (the difference) is usually 1-2%.

Additionally, because all Canadian banks are competing (bidding for) government bonds the competition any increased competition means that equivalent bond yields (the percentage return that the bank/institution/investor will receive) get much smaller.

As the example above, a 5-year Government of Canada bond is yielding about 3.5% today and most 5-year discounted mortgage rates are set at about 7.20%.

This means that the chartered banks are earning a whopping risk premium of 3.70% before expenses.

When it is costing banks more to get the money they lend to you – they transfer this extra cost to you by way of increasing their lending rates – 5 year mortgages in our example…

Conversely, when it costs banks less to get the money they lend to you – they reduce their lending rates.

However, they always have their profit margin built in there – no matter if rates are going up or down!

Bear in mind that all Canadian mortgage lenders are very aware that their current or potential retail depositors can choose to put their money into none of the financial institutions GIC’s and may instead opt for purchasing other “fixed income securities” such as bonds, which yield a higher rate because they adjust immediately to market changes and they can even switch their funds into the stock market if this is performing relatively better.

Therefore, in the truest sense of the word, the mortgage lending institutions are competing with other markets for the investor’s money.

If a bank doesn’t attract enough depositors to fund all the mortgages, they’ll have to go where their depositors go – the money markets – to make up the difference….and there, they pay the going rate!

But of course, we have always known this…but now you know: “the rest of the story”…

My suggestion to anyone who wants to predict when mortgage rates will rise and fall is to track Government of Canada bond yields daily.

Most financial papers list the bond yields for various terms each day.

It is normal for yields to change slightly from day to day, but if you start to see consistent increases or decreases then you can expect that the banks will be adjusting their mortgage rates accordingly.

If you are interested in a 5-year mortgage rate then track the equivalent 5-year Government of Canada bond; if you are interested in a 1-year mortgage rate then track the equivalent 1-year Government of Canada bond, and so on.

Now that I have told you that the Bank of Canada does not have an impact on mortgage rates, there is one exception to this rule.

Most variable rate mortgages are affected by changes to the prime rate as set by each of the chartered banks.

The prime rate will change, in the same direction and by the same amount, as any change to the overnight rate.

So if the Bank of Canada announces a decrease in the overnight rate by one quarter of 1% (or “25 basis points” in financial parlance), then you can expect most variable rate mortgages to also drop by one quarter of 1%.

So unless you have a variable rate mortgage, don’t pay attention to the hype surrounding interest rate announcements by the Bank of Canada.

If you want to know where fixed rate mortgage rates are headed, follow changes in the bond market.

Now you know how mortgage interest rates are set!

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About The Author – Mark Huber, CFP

How To Pay Off Your Mortgage Faster was founded by Mark Huber in 1998.
Mark is an expert certified financial planner (CFP) with over 28 years of experience in the financial services industry...
Mark is also a speaker, coach and the author of:
And "The best way to predict your future is to create it...."